What is a 401(k) Plan?

The term '401(k) Plan' is included in the Investments edition of the Financial Dictionary. Get yours now on amazon in ebook or paperback format. Read more here...

401k retirement plans are specific kinds of accounts that the government established to help individuals to plan and save for retirement. Individuals fund these accounts using pre-taxed dollars from payrolls.

People invest money in these accounts into several different types of investments. These include stocks, mutual funds, and bonds. Gains earned in the account include dividends, capital gains, and interest. These gains do not get taxed until the owners withdraw the funds.

The name of the 401k comes from the portion of Internal Revenue Service Code which pertains to it. This vehicle for saving for retirement began in 1981 when an act of Congress created it.

There are a number of benefits to 401k accounts that recommend them to individuals. Five of these include tax benefits, flexibility of investments, employer matching programs, loan abilities, and portability.

The advantageous tax benefits are one of the main reasons that 401k plans are so popular. Money contributed does not become taxable until individuals withdraw it. Similarly gains accrued in the account are also tax-deferred. Over several decades, this makes a significant difference in the amount of money that people can save.

Investments that the IRS allows in these 401k retirement plans provide some flexibility. Those who do not want to take on much risk can choose to put more of their funds into shorter term bonds which are lower risk. Others who are more concerned with developing wealth over the long term can put a larger percentage of the money into equities like stocks and mutual funds. Company stock can also be acquired at a discount with many employers.

A tremendous edge that these 401k retirement plans provide their owners is the employer match feature. A great number of employers match their employees’ contributions as a company benefit. This is done on a percentage basis. Newer employees may receive a 25% of contributions match, while employees who have been at a company longer may receive 50% or even 100% matches. Matches are only made on a certain maximum percentage of income that an employee contributes. This is the closest thing to free money a person can obtain at work.

Loan abilities from 401k retirements are a helpful feature for individuals in times of need. When people find themselves needing money with no other place to turn, the government permits them to obtain 401k loans from the plan. The plan administrator has to approve it as well. Loans from 401k plans are not taxed or penalized so long as they are repaid according to the repayment schedule and terms.

There are no restrictions on the uses of such loans. Some employers have minimum amounts that can be borrowed of $1,000 and a maximum number of loans an employee can take at a time. Sometimes employees will have to get their spouse’s written consent before the company will issue the loan.

There are limits on the amount of a balance that can be borrowed. This is typically as much as 50% of the vested balance to no more than $50,000. When an employer will not allow an employee to take out a loan against the plan, hardship withdrawals can be requested. These are taxed and also penalized at a 10% rate.

Portability means the 401k retirement plan can go with the employees as they change jobs. Investors have four different choices for their 401k plan when they move to another company. They can choose to leave the plan with the old employer and pay any administration fees for the account staying there. They might instead do a rollover of their account to the new employer’s 401k retirement plan.

A third option is to convert the 401k retirement plan into an Individual Retirement Account. Finally they might decide to close the 401k and receive the proceeds in cash. This would mean all money would be subject to taxes and the 10% penalty fee.

The term '401(k) Plan' is included in the Investments edition of the Financial Dictionary. You can get your copy on amazon in Kindle or Paperback version. See more details here.